Volatile equity markets can be scary for retirees—but for savvy investors, they can also be an opportunity.

Using a sophisticated options strategy, the Nationwide Risk-Managed Income ETF (NUSI) seeks to harness the volatility of the markets as a way to generate consistent current income.

The fund uses covered calls on the NASDAQ 100 Index—in other words, the manager sells call options owns an equivalent amount of the underlying NASDAQ 100 securities. Call options give the holder the right but not the obligation to buy the underlying asset. As such, covered call strategies have the potential to generate a steady income stream.

NUSI’s day-to-day options management is handled by its sub-advisor, Harvest Volatility Management, a shop that specializes in derivatives and volatility investing.

Recently we sat down with Curt Brockelman, the cofounder and managing partner of Harvest Volatility Management, to dig under NUSI’s hood and learn more about what makes the fund tick.

 

Lara Crigger, Managing Editor, ETF Trends: Tell us a little about Harvest Volatility Management and how the partnership with Nationwide came to be.

Curt Brockelman, Managing Partner and Cofounder, Harvest Volatility Management: Back in 2008, my partner Rick and I started Harvest Volatility Management to help investors achieve their goals using derivatives and volatility. Most of our strategies are based around income and hedging for investors. We built a team of experts around options pricing and volatility of markets.

A couple years ago, we helped Nationwide design NUSI. What they were trying to find is: How do you find income in a low yield world? How can retirees plan for and build their retirement, but also then live in that retirement with current income? Bonds were great in the ‘90s, when money markets yielded 5%, but these days, it’s much tougher to find yield. Back in ’07, ’08, we had the same sort of low yield environment, and clients started taking credit risk, duration risk, and leverage risk in their portfolios, because they had to find income somehow.

Crigger: They didn’t have much choice.

Brockelman: Well, unfortunately, everyone found out what happens when you have a lot of leverage, credit risk or a long duration portfolio that’s unhedged. Those were stressful, problematic times for a lot of retirees.

At Harvest, we wanted a portfolio that had relatively low credit risk, low duration risk, but which could generate high income and have low correlation to interest rates in general. So that’s why came up with NUSI.

Crigger: Tell us a little about the particular options strategy underpinning NUSI.

Brockelman: Basically, we buy the NASDAQ 100 [Index], which is a growth portfolio with a lot of tech names and very low credit risk. The companies carry high cash balance sheets; they have a growth aspect to their risk. But the volatility of the NASDAQ is high—in 2008, that went down 55%. But because of that volatility, we believe that the option pricing is really attractive for writing covered calls.

So we write covered calls [on the NASDAQ 100], which takes out some participation in the upside, but does leave some. And we vary that strike price based on our expertise, and our models. [Author’s note: The “strike price” of an options contract is the price specified in the contract at which the owner can buy/sell the underlying asset.] We take some of that premium we generate for capping the upside and with it, buy put options for the portfolio.

So you have an income generator in the call side; and if the market doesn’t go anywhere, we collect all the call premium. Yes, we spent a little bit for the put option, and we’ll lose that, but if the market goes up, we have a spread. But when the markets turn, like they did last March, we have some downside protection.

As a result, you end up with a lower volatility strategy that could be able to generate a high amount of current income to be paid out, and over time, may appreciate with the growth of the market. Readers can go to our website to see more information about how the fund has performed and what its current yield has been since inception.

Crigger: Are the particular sector or industry exposures within the NASDAQ 100 as relevant as the income you’re trying to generate?

Brockelman: Not particularly. We chose the NASDAQ 100 because it has a growth component; meaning, over time, we believe that it may compound well to the upside. Also, it has relatively high volatility in relation to the overall market; and therefore higher volatility pricing for the options. Because of that growth component, we’re getting paid more for a NASDAQ 100 covered call, than we would, say, something on the MSCI All-Country World Index (ACWI).

Crigger: So even though you’re seeking to provide a less wild ride, a more volatile market is actually good for you, in that it helps you accomplish the objective of the fund.

Brockelman: It’s not that when volatility is high, it’s a great time to get into this ETF; and when volatility is low, it’s a bad time. Because when volatility is lower, we’re collecting less premium but we’re able to buy better tighter put spreads. So it’s designed to work in all market cycles.

Crigger: Over the past year or two, there’s been a substantial rise in investors’ comfort level with options. Five years ago, an ETF that used options couldn’t get assets to save its life. That’s not the case anymore. Options investing is striking a chord with investors—even with retirees, the most risk-averse investor class you can find. What’s changed?

Brockelman: Yeah, I’ve been doing derivative portfolios for 25 years now, and over the years, I’ve met lots of people who say, “I don’t do derivatives investing.” And, usually, it comes back to a bad experience. Maybe they didn’t understand the leverage that’s embedded in the portfolio, which led to large losses. But there was one interesting conversation I had with an insurance guy who told me, “I hate derivatives.” Turns out, he’d bought a midcap growth manager who’d sold covered calls every month against their positions… in March of ’09, at the bottom of the market. That’s using the tool of derivatives incorrectly.

I think what’s changed is that people have come around to the idea that [options]are a tool. As long as they understand how that tool affects their exposures and what their risk is—a tool isn’t good or bad, right? A hammer in the right hand will help you build your house, but a hammer in the wrong hands will take your house apart.

Also, I think it’s because people have had to become more creative about how they think about income. Derivatives are a way to seek to generate incremental yield or additional yield. So I always say to people, you have to understand what the tradeoff is. You can go way to the upside, but you might be more levered. So if the market turns down… then what will you do? You have to understand the potential outcomes in and run scenarios of if the market goes up 20% or down 20% — you have to understand how your tools operate in different environments.

The nice thing is technology has improved so much that now even retail investors have access to robust options pricings, scenario analyses, and other opportunities that weren’t available 10 years ago. That’s given some comfort, too.

Crigger: Let’s take a 30,000 foot view of what’s facing retirees right now. There’s been a lot of talk about inflation lately—lots of fears that we’re seeing is a big pickup in inflation, or even reflation. Others are saying: Not so fast; what is happening is purely transitory. Where do you fall on that spectrum? What are your inflation expectations, going into the rest of the year and beyond?

Brockelman: Inflation is a scary word for a lot of people, because they don’t understand it. Here’s how we view it: Inflation is purchasing power. We can talk about currencies and how the Consumer Price Index is accurate or inaccurate. But we look at it like this: Can you fill up your gas tank for less than you could some number of years ago? Can you buy a dozen eggs for less? Those sorts of things are important. Are you gaining or losing purchasing power? And historically, retirees on fixed incomes lose purchasing power.

We do think inflation is rearing its head. For the last two years, we’ve seen real price inflation. But we have not seen real wage inflation yet. We’re just now starting to see wage growth. People are raising minimum wages to $15 an hour. Bank of America is raising their minimum wage to $25 an hour. So we are going to start seeing some upward wage pressures, which can lead to upward wage costs, or wage costs on a spiral.

Historically, there’s been things like efficiencies and globalization that have been able to keep prices relatively low. But with this, this next leg of potentially wage pressure, you could see costs escalate, which would be inflationary.

Historically, when you have inflation, because of the uncertainty and how governments and investors react [to that uncertainty], you tend to get asset volatility across all assets. So I think we’ll see higher asset class volatility across all assets, bonds, equities, and other asset classes. In that transition time, you’ll want to have hedged equity at play.

Crigger: What about interest rates? If the Fed raises rates, does that negatively impact NUSI?

Brockelman: No, because higher rates may lead to a contraction, most likely in multiples on the equity, which means maybe the NASDAQ could go down. But again, we’ve sold the covered call against that. So we’ll seek to generate that income every month. We tried to design NUSI for that, to make it through all different kinds of market cycle scenarios.

For more information, please visit the Retirement Channel.


This article was prepared as part of Nationwide’s paid sponsorship of ETF Trends.

Performance data quoted represents past performance; past performance does not guarantee future results. Index performance is not illustrative of fund performance. One cannot invest directly in an index. Please call 1-877-893-1830 for fund performance.

ETFs, hedge funds, equities, bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value. Investing involves risk, including the possible loss of principal. Shares of any ETF are bought and sold at market price (not NAV), may trade at a discount or premium to NAV and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. The Fund’s return may not match or achieve a high degree of correlation with the return of the underlying index.

NUSI Prospectus (hyperlink to: https://nationwidefunds.onlineprospectus.net/nationwidefunds/NUSI/index.html )

Call 1-800-617-0004 to request a summary prospectus and/or a prospectus. You may also download the prospectus at the link above or by visiting etf.nationwide.com. These prospectuses outline investment objectives, risks, fees, charges and expenses, and other information that you should read and consider carefully before investing.

KEY RISKS: The Fund is subject to the risks of investing in equity securities, including tracking stock (a class of common stock that “tracks” the performance of a unit or division within a larger company). A tracking stock’s value may decline even if the larger company’s stock increases in value. The Fund is subject to the risks of investing in foreign securities (currency fluctuations, political risks, differences in accounting and limited availability of information, all of which are magnified in emerging markets). The Fund may invest in more-aggressive investments such as derivatives (which create investment leverage and illiquidity and are highly volatile). The Fund employs a collared options strategy (using call and put options is speculative and can lead to losses because of adverse movements in the price or value of the reference asset). The success of the Fund’s investment strategy may depend on the effectiveness of the subadviser’s quantitative tools for screening securities and on data provided by third parties. The Fund expects to invest a portion of its assets to replicate the holdings of an index. Correlation between Fund performance and index performance may be affected by Fund expenses and because the Fund may not be invested fully in the securities of the index or may hold securities not included in the index. The Fund frequently may buy and sell portfolio securities and other assets to rebalance its exposure to various market sectors. Higher portfolio turnover may result in higher levels of transaction costs paid by the Fund and greater tax liabilities for shareholders. The Fund may concentrate on specific sectors or industries, subjecting it to greater volatility than that of other ETFs. The Fund may hold large positions in a small number of securities, and an increase or decrease in the value of such securities may have a disproportionate impact on the Fund’s value and total return. Although the Fund intends to invest in a variety of securities and instruments, the Fund will be considered nondiversified. Additional Fund risk includes: Collared options strategy risk, correlation risk, derivatives risk, foreign investment risk, and industry concentration risk.

Nasdaq-100 Index: An unmanaged, market capitalization-weighted index of equity securities issued by 100 of the largest non-financial companies, with certain rules capping the influence of the largest components. It is based on exchange, and it is not an index of U.S.-based companies. Market index performance is provided by a third-party source Nationwide Funds Group deems to be reliable (Morningstar). Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses have been reflected. Individuals cannot invest directly in an index.

S&P 500® Index: An unmanaged, market capitalization-weighted index of 500 stocks of leading large-cap U.S. companies in leading industries; gives a broad look at the U.S. equities market and those companies’ stock price performance.

The Consumer Price Index measures the average change in prices over time that consumers pay for a basket of goods and services.

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